The moment entrepreneurs accept outside capital, they need a strategy for paying back their investors. Ideally, angel funding leads to venture capital, then private equity, with the process culminating in a profitable sale or initial public offering.
Entrepreneur Jai Shekhawat, founder and chief executive of Chicago technology firm Fieldglass, knows a tough economy can slow down that cycle, yet he has a knack for finding opportunity and seizing it. He raised millions after the dot-com bubble burst when few other start-ups did. And this fall, at a time when few large deals were done, Shekhawat agreed to a buyout by Madison Dearborn Partners in a deal that values Fieldglass at $220 million.
A window of opportunity
Shekhawat, who will stay on as CEO of the provider of software as a service for procuring and managing contingent labor, said he is taking advantage of the window of opportunity to pay back his investors and cash out before the capital gains tax rate rises as expected in January. “If you’re going to do something near term, you may as well do it this year rather than next year,” Shekhawat said.
When negotiating deals, timing can be critical, and the challenging economy shouldn’t deter entrepreneurs from seeking capital or cashing out their businesses, experts said. In fact, the current low capital gains tax rate has been spurring transactions because the tax rate is set to increase Jan. 1. “I definitely think that’s got some people moving, but people are moving anyway,” said Domenic Rinaldi, managing partner, Sunbelt Business Brokers in Chicago. “The market has been very active. Lots of people are looking for opportunities.”
The Madison Dearborn buyout provides an exit strategy for Fieldglass’ investors, which include Prism Opportunity Fund, Grotech Ventures, BlueStream Ventures, StarVest Partners, HLM Venture Partners and RBC Capital Markets. “We had existing investors for 10 years. There had to be a time when they were looking for liquidity,” Shekhawat said. “I’d rather do it on my own terms” than theirs.
Global growth plans
It helps that Fieldglass is enjoying sales growth of about 50 percent this year, on top of a 33 percent hike in revenue in 2009, Shekhawat said. The company currently employs 135 workers and has been hiring to support its growth.
While Shekhawat said Fieldglass is “quite profitable,” he agreed to the Madison Dearborn buyout because it will allow Fieldglass to expand quickly overseas, where it currently is in 70 countries. “You set up for the next leg of your journey,” he said. “We needed a bigger institutional partner, someone who can share our vision” of a larger international presence.
Mining personal connections
The deal came together quickly because Shekhawat and Madison Dearborn managing director Doug Grissom know each other from working together at McKinsey & Co. years ago. Typically, entrepreneurs look first in their own network for funding, said Jeffrey Sohl, director at the Center for Venture Research at the University of New Hampshire.
That’s been the case for Shekhawat, who launched the technology company in November 1999 with a single check from a business colleague. Then he convinced 26 others to chip in a combined $1.2 million. That angel funding led to several rounds of venture capital to the tune of about $38 million, with most raised after the dot-com bubble burst — not an easy time to nab investments, Shekhawat said. The capital allowed the company to expand rapidly, and its vendor management software is now regarded as the standard for procuring and managing contingent labor.
By allowing investors to exit, the deal with Madison Dearborn could help stimulate investments in new start-ups, experts said. Shekhawat knows firsthand that outside funding can be critical to a start-up’s success. “Without venture capital, I wouldn’t even be in business,” Shekhawat said in an interview in 2004.
Angel funding down in 1st half
While new ventures are considered the job engines of the economy, many have struggled to grow and hire because of lack of available capital. Besides the credit crunch, which impacted bank loans and lines of credit, seed funding by angel investors declined 6.5 percent in the first half of 2010 from the year-ago period, hitting its lowest level in several years, according to the Center for Venture Research.
Many venture capital investors are keeping existing companies in their portfolio for the time being, reducing the amount of seed money available for new firms. Rather than exiting at a low valuation, the investors are “just keeping what they have afloat,” Sohl said.
What’s more, about 65 percent of the membership in angel groups were “latent angels” in the first half of the year, or those who have the net worth but haven’t made an investment, suggesting a high level of caution among investors, Sohl said. Some may have sold investments to take advantage of low tax rates, but haven’t invested again yet.
Factoring in tax savings
The long-term capital gains tax rate is expected to jump to 20 percent in 2011 from its current 15 percent for taxpayers with household incomes of $250,000 or more, representing a 33 percent increase, said Jeff Arnol, managing partner of accounting firm Kessler Orleans Silver & Co. For example, on the sale of a business that generates a $2 million gain, the seller would owe an additional $100,000 in capital gains tax next year, he said. “This might sway you to do something now versus later,” Arnol said.
Tax breaks not enough
At the same time, few believe a tax incentive designed to spur investments in new C corporations will make a difference. The incentive, passed in September as part of the Small Business Jobs Act of 2010, eliminates capital gains tax on investments in qualified small business stock made before the end of the year. Up to $10 million or 10 times the taxpayer’s investment in the stock is eligible for the exclusion. To qualify, businesses must be structured as a C corporation, must have less than $50 million in assets and the investor must hold the stock for at least five years.
But research indicates the tax incentive ranks low among factors affecting investors because it takes too long for investors to realize the tax break. “The exit is so far away” from the time of investment, Sohl said.
What’s more, factors such as the strength of the business concept and the experience of the management team ultimately are more important to investors than a tax incentive because they indicate the likelihood of making money on the deal, said Rich Salter, accountant at Steinberg Advisors in Northbrook.
“Everyone’s biggest concern is, is it a good business decision?” Salter said.